If you want to understand where China is heading, the best guide may be private equity veteran Weijian Shan. His take on his country’s current economic predicament: Its slowdown has only just begun, but its long-term health looks sound.

Shan’s perspective is so valuable because he views his homeland’s economy from three contrasting vantage points that few, if any, experts can match: As an on-the-ground dealmaker in his role as chief of PAG, Asia’s largest private equity firm; as a U.S.-trained, PhD economist; and as a figure whose personal story followed his nation’s rise, from the brutal oppression that exiled him into forced labor during the Cultural Revolution to the economic miracle that enabled him to bring billions of dollars in gains to his investors.

On a Tuesday evening in late January, I met Shan at a modest cafe on Manhattan’s Upper West Side. Shan––who later mentioned he was attending a board meeting by phone later that evening––ordered a cup of hot water.

Though he lives and works in Hong Kong, Shan was in town to promote his new book, Out of the Gobi: My Story of China and America. It chronicles the nightmare of being torn from his family in Beijing as a teenager in 1969 and sent to the Gobi Desert, where he toiled as a laborer for six years. Shan relates how China’s liberalization under Deng Xiaoping enabled him to join the first generation dispatched by the government to study in the U.S.

Shan earned a doctorate in international business at U.C. Berkeley, where he wrote his PhD thesis under the tutelage of future Federal Reserve chair Janet Yellen, then joined the faculty at the Wharton School. The book’s epilogue is a heartbreaking account of his return the crumbling, abandoned barracks where he once toiled as a “barefoot doctor,” one of a cadre of rural Chinese given basic medical training to treat minor illnesses. He encountered old friends who turned to pig farming because they could no longer scratch a living from the parched soil. “We had spent so much of our youth battling nature to turn this land into arable farms,” he writes. “Eventually, nature prevailed and took it back.” This final chapter is a eulogy for his comrades, victims of the notorious “Cultural Revolution’ who “had been denied a future, wasting their best years when they should have been in school. For what?”

The end of an era in China

Out of the Gobi doesn’t encompass the business career that took him back to his homeland, but in our conversation, Shan noted that his ultimate ambition was to help provide the capital to build private enterprise in China and other Asian countries. After a five-year stint with J.P. Morgan in Hong Kong, he joined private equity colossus TPG in 1998. He spent the next 12 years at TPG, then in 2010 co-founded PAG, where he serves as chairman and CEO. He has built that firm into a giant with $30 billion in capital under management.

Shan is full of praise for China’s ascent over the past two decades, but he warns that the era of epic growth is ending. His observations blend what he sees in the C-suites in Shanghai and Beijing with his insights as an economist. “I wouldn’t be surprised if GDP falls to 6% in 2019,” he says, a rate below last year’s already disappointing 6.6%, one of the lowest readings since 1990.

Shan reckons that two short-term forces are contributing to the current softness, but cautions that it’s the durable, secular shift away from fast-expanding manufacturing that ensures that China will jog rather than sprint in the future.

The first of two immediate problems, he says, is a severe contraction in credit. “Two years ago, the government started cracking down on the ‘shadow banking’ network that provided most of the credit to the private sector,” he says, adding that private enterprise is dominated by small and medium-sized businesses (SMEs) in China. Beijing was worried that trust companies and other lenders in the “shadow” system were dangerously over-extended, and the motley group might crash, hobbling the economy.

At the same time, the government tried to ensure that the state-controlled banks kept credit flowing by dictating that they target at least 50% of their lending to SMEs. “But the big banks didn’t want to lend to private companies because they’re riskier credits,” says Shan. “They always wanted to loan money to the big state-owned enterprises, [SOEs] because they’re backed by the government, and totally safe.” Because the banks resisted, he says, “the quotas didn’t work.” His view: The private sector isn’t getting the bank financing it needs for new plants, medical facilities and stores––a phenomenon that’s now slowing the economy.

The second deadweight is the trade dispute with the U.S. “The direct impact on business is small,” he says. “But the impact on business confidence is large. The dispute is hitting confidence among Chinese producers, and discouraging them from investing.”

To help resolve the conflict, says Shan, China should lower its tariffs on U.S. imports, and lift barriers to U.S. ownership of Chinese companies. “That would lower prices to consumers on cars, cell phones and other U.S. imports, and also force Chinese rivals to become more competitive,” he says. “Making those products cheaper would give consumers more money to spend on other products, on appliances or groceries. And that would help growth. Since China is becoming much more of a consumer society, it’s getting more and more important to promote competition and efficiency in what’s now the bulk of the economy.”

Less manufacturing, slower growth

Indeed, says Shan, China’s shift from a manufacturing to consumer-led economy is what will inevitably slow its future growth. China’s economic destiny is being dictated by its demographics. It’s long been clear that the “one-child policy” would eventually constrict China’s workforce. (That policy was ended in 2015.)

For Shan, that problem was alleviated, and masked, by the giant migration from rural areas to the cities. “Exactly fifty years ago, when I was sent to the Gobi, China began the greatest ‘ruralization’ in human history,” says Shan. “Out of 160 million people living in cities, 16 million were sent to farms and barren areas. For the past twenty years, we’ve seen the greatest urbanization in human history. It’s that migration of peasants and farmers to urban factories that drove China’s industrialization.”

That trend, he now warns, has peaked. “China is now facing a tight supply of workers that’s driving up labor costs,” he says. “Labor costs have risen 11% a year for the past decade, while prices of the exports China manufactures are flat or declining. That’s why China is now losing exports to other Asian nations such as Vietnam and Indonesia.”

Chinese industry was once hungry for investment, and the Chinese, faced with a meagre choice of consumer goods at home, saved most of their incomes. Those savings swelled the bank deposits that funded China’s mighty rise in manufacturing. Those days are over. Today, a much bigger share of workers’ paychecks are going to Nike sneakers, fancy foods, and vacations in Hong Kong or Paris. “The old model of saving to invest no longer works,” says Shan. He points out that ten years ago, exports, a proxy for manufacturing, accounted for 36% of GDP and consumption 35%. Over that span, exports have dropped to 19% of national income, and consumption has jumped to 50%.

A nation driven by heavy investment in manufacturing is a lot more dynamic than an economy dominated by consumer spending, says Shan. “Private consumption produces lower growth than than manufacturing investment,” he notes. He explains that a growing industrial base creates a “multiplier effect.” Each trillion yuan in invested in a new factories contributes far more than that in economic growth by creating new jobs and still more factories to supply components and power. “Conversely,” says Shan, “consumption spending doesn’t provide a multiplier. It doesn’t provide the impetus for growth that investment in manufacturing does.”

Shan’s conclusion: The historic shift from manufacturing to consumption is bound to slow China’s future expansion. He adds, however, that China still has lots of room to improve its growth profile by downsizing the state-owned sector, and further encouraging expansion of private industry. And those sources of efficiency will be needed simply to sustain current levels of growth.

What about predictions that Beijing will enact a big stimulus package to re-ignite growth? Shan doesn’t think it will happen. “China certainly has the capacity to do it,” he says. “Its finances are in better shape than any other major economy. The central government’s debt to GDP ratio is just 17%, it has $3 trillion in foreign exchange reserves, and foreigners own a tiny amount of its sovereign debt.” But he predicts that the government will avoid opening the monetary floodgates. The policies of the past two years, he says, are specifically aimed at curbing what Beijing viewed as excess leverage for both consumers and businesses, potentially creating asset bubbles that once exploded, could sink the economy. For Shan, the government views the risks of excess credit as more damaging than the drag on growth from restricting credit.

A real estate bubble? Not likely

Some concerns about China center on the rapid escalation in prices for housing and other real estate, and the possibly disastrous aftershocks if prices fall sharply. Shan sees those fears as overblown: He doesn’t see a replay of the U.S. financial crisis of 2008 to 2010, or the Asian collapse in the 1997 and 1998.

“Both [those crises] were caused by a collapse in real estate, but the key is that the real estate collapse wrecked the banking system, causing a credit crunch that led to deep recessions,” says Shan. “In the late ’90s, hundreds of Asian banks failed; we [at TPG] bought several of them.” The difference, he continues, is that Chinese federal laws and banking guidelines have limited leverage in the real estate market, limiting the danger to the banks.

He lists four reasons that real estate isn’t dangerously leveraged, and hence why the banking system is well protected. “First, the banks will lend no more than 70% to 80% of the purchase price,” he says, “meaning the homebuyer has substantial equity. Second, prices have risen a lot, and existing homeowners have already paid down part of their loans, so their equity across the economy is more like 50%.”

A third factor: The Chinese are personally liable for the entire amount of their home loans. They can’t walk away if they face foreclosure, as millions of Americans did in the financial crisis. “In the Asian financial crisis, for example, homeowners in Hong Kong kept paying even when they were under-water,” says Shan. “There were few foreclosures, while in other parts of Asia, foreclosures flooded the market with homes.”

A fourth safeguard arises from the widespread restriction on owning more than one home. “That means the Chinese families are a lot less exposed than if they owned a main house, but also a vacation home and another place for investment,” he says. All told, Shan concludes that even if housing prices dropped 30%, that scenario would still would pose little threat to the banking system. Such a fall, he cautions, would still leave a big hangover– in the form of the “wealth effect.” “If housing prices fall and consumers feel a lot poorer, they’ll spend a lot less, and growth will falter,” he says.

Betting on Chinese consumers

Its hardly surprising that Shan’s favorite sector for investing is consumer products and services that he says are China’s future, rather than the heavy industry that once defined its incredible ascent. “We see the best opportunities in health care, pharmaceuticals, specialty finance, and food and beverage,” he says. “We’re talking about 1.4 billion consumers who are consuming more and saving less every year.”

PAG just scored a spectacular success in music. Shan explains that about just five years ago, PAG made a $100 million investment in China Music Corp, a company that for years was either buying up or licensing virtually every pop music copyright it could in China, and also for Western music targeting the Chinese market. “Those copyrights and licenses were selling for peanuts,” says Shan. “That’s because ten years ago there was so much pirating and illegal copying of music, that the copyright protections were almost worthless.”

But over time, he says, the government enacted strong new laws shielding China’s intellectual property, and the courts greatly improved enforcement. To boot, music lovers began shunning scratchy-sounding copies made by the pirating shops.

In mid-December 2018, Tencent Music Entertainment, created from a merger of China Music and QQ Music, went public on the Nasdaq, and now carries a market value of $26 billion. PAG’s holdings are worth a few billion dollars. “We have 800 million unique monthly users,” says Shan. The Tencent Music story, he says, epitomizes what he calls China’s shift from the world’s factory to the world’s market. Fully opening that market, says Shan, would both benefit the Chinese consumer, and reinvigorate the now-endangered trading partnerships that so enriched its past and are so crucial to its future.